Transition Risk: Investment signals in a decarbonising electricity system

This working paper is an update to our November 2021 briefing paper: Risk and investment in zero-carbon electricity markets.

Rapid deployment of renewable energy is at the forefront of the UK government’s plans to decarbonise the power sector by 2035, as a precursor to meeting broader net zero aspirations by mid-century. The British Energy Security Strategy (April 2022) highlighted the importance of offshore wind in particular, and extended previous aspirations by setting an ambition to deliver up to 50 GW offshore wind by 2030, including up to 5 GW of floating wind.

Installing 30-40  GW of new offshore wind in nine years is a significant challenge. It requires amongst other things the mobilisation of something of the order of £55-70 billion of investment. However, this is just the beginning. Scenarios from National Grid ESO, the Great Britain system operator, put the amount of wind needed for a fully decarbonised system at between 80-110 GW by 2040 requiring investment of up to £160 billion.

Challenges for investment

As electricity markets shift away from fossil fuels towards low carbon technologies with low marginal costs of production, the wholesale price of electricity will tend to drop (so-called ‘price cannibalisation’) which could adversely affect investment signals. The degree to which this occurs depends on the nature of the supply and demand technologies that come on to the system during the decarbonisation pathway, as well as the prevailing policy framework. We use the term ‘transition risk’ to describe risks that investors face relating to this pathway uncertainty, and show these risks can significantly increase the cost of achieving decarbonisation.

At the same time, the energy price shocks of 2022 have shone a harsh spotlight on risks to consumers, emphasising the need for policy to take account of allocation of risk between generators and consumers both of higher- and lower-than-expected prices.

This report assesses the impact of these risks on the financial case for offshore wind, using a methodology that can be readily applied to other types of generation. We also review international policy experience to assess different approaches to incentivising investment in renewables.

Key messages:

• We characterise the current stage of the low-carbon transition as a ‘build phase’, where large volumes of investment are needed to get on a path to a net-zero electricity system.
• International experience indicates that successful policies to achieve this investment have in common the ability to provide a steady, stable and predictable outcome for investors.
• During the build-phase, the final physical state of the decarbonised system is still uncertain, meaning there is significant price risk in future wholesale markets.
• Current ‘contracts for difference’ provide a fixed price for renewables, shielding investors from these risks, helping to minimise the cost of capital for these projects during this critical build-phase of the transition.
• Exposing projects fully to transition risk at this stage could increase the cost of transition by at least a third (from £15bn to around £18-£20bn per year for offshore wind alone).
• A number of market design options that provide an alternative to use of CfDs to address price cannibalisation may become feasible and attractive in the longer-term once the risk characteristics of the decarbonised system are better understood.